US GAAP - Issues and Solutions for Pharmaceutical and Life Sciences: Chapter 3

Chapter 3: Manufacturing & Supply

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3-1 Treatment of validation batches

Background

A laboratory has just completed the development of a new machine to mix components at a specified temperature to create a new formulation of aspirin. The laboratory produces several batches of the aspirin using the new machinery in order to obtain validation (an approval for the use of the machine) from the relevant regulatory authorities. The validation of the machinery is a separate process from the regulatory approval of the new formulation of aspirin.

Question: Should expenditures to validate machinery be capitalized?

Solution

Because validation is required to bring the machinery to its working condition, the laboratory should capitalize the costs incurred (including materials, labor, and applicable overhead) to obtain the necessary validation, together with the cost of the machinery. However, management should exclude abnormal validation costs caused by errors or rework during the validation process (such as wasted material, labor, or other resources). If later the machinery requires revalidation (after the initial validation and subsequent use), the costs related to this would be expensed as incurred as the asset had already been prepared for its original intended use.

Generally, any costs associated with validation batches that can be sold after the machinery is approved, should be accounted for as part of inventory.

Relevant guidance

CON 5, par. 67(a): Property, plant, and equipment is reported at historical cost which is the amount of cash, or its equivalent, paid to acquire an asset, commonly adjusted after acquisition for amortization or other allocations…

ASC 835-20-05-1: ...The historical cost of acquiring an asset includes the costs necessarily incurred to bring it to the condition and location necessary for its intended use. If an asset requires a period of time in which to carry out the activities necessary to bring it to that condition and location, the interest cost incurred during that period as a result of expenditures for the asset is a part of the historical cost of acquiring the asset.

3-2 Treatment and presentation of development supplies

Background

Company A, a laboratory, has purchased 10,000 batches of saline solution. These batches are used in trials on patients during various Phase III clinical tests. They can also be used as supplies for other testing purposes, but have no other uses (i.e., Company A has no intention to sell the batches in the future). Management is considering whether the batches should be recorded as an asset.

Question: Should costs associated with supplies used in clinical testing be accounted for as inventory?

Solution

The batches do not meet the definition of inventory in ASC 330-10-20 because they are not held for sale, or consumed in the production of goods to be sold. However, the batches meet the definition of an asset (other current asset or prepaid asset) since they have alternative future uses in other development projects. They should therefore be recorded at cost and accounted for as supplies used in the development process. When supplies are used, the associated cost forms part of research and development expense.

Relevant guidance

ASC 330-10-20: Inventory: The aggregate of those items of tangible personal property that have any of the following characteristics: (a) held for sale in the ordinary course of business, (b) in process of production for such sale, or (c) to be currently consumed in the production of goods or services to be available for sale…

ASC 730-10-25-2-(a): …The costs of materials (whether from the entity's normal inventory or acquired specially for research and development activities) and equipment or facilities that are acquired or constructed for research and development activities and that have alternative future uses (in research and development projects or otherwise) shall be capitalized as tangible assets when acquired or constructed. The cost of such materials consumed in research and development activities and the depreciation of such equipment or facilities used in those activities are research and development costs. However, the costs of materials, equipment, or facilities that are acquired or constructed for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred…

CON 6, par. 26: An asset has three essential characteristics: (a) it embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows, (b) a particular entity can obtain the benefit and control others’ access to it, and (c) the transaction or other event giving rise to the entity’s right to or control of the benefit has already occurred…

3-3 Accounting for demonstration equipment

Background

Company A produces manufacturing equipment. It provides its sales representatives with demonstration equipment that can be loaned to potential customers for a period of time before sale to the customer or return to Company A.

Question: How should Company A account for demonstration equipment?

Solution

Demonstration equipment is classified as inventory or fixed assets depending on a number of factors, including the nature of the equipment, the length of time it remains in the field prior to being sold, and management’s intent (i.e., to sell, place with another customer, continue to  loan). The longer a unit remains in the field before being sold or if it is used by sales representatives to demonstrate the equipment to multiple potential customers, the more likely it is that the equipment is a productive asset of the company. It should then be classified as a fixed asset and depreciated over its estimated useful life down to its estimated recoverable value. Equipment that remains in the field for a relatively short period prior to sale are generally classified as inventory and are not depreciated like a fixed asset.

Equipment that can be readily repaired or restored is more likely to be inventory than is a product that cannot. The need for a reserve to write the units down to their lower of cost or net realizable value (if classified as inventory) or their fair value (if classified as fixed assets) as a result of technological advances or physical wear and tear should be considered. The cash flow presentation of the purchases of such equipment should generally be consistent with the balance sheet classification (i.e., investing for fixed assets, operating for inventory).

Relevant guidance

Con 6, par 25: Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

ASC 330-10-20: Inventory: The aggregate of those items of tangible personal property that have any of the following characteristics: (a) held for sale in the ordinary course of business, (b) in process of production for such sale, or (c) to be currently consumed in the production of goods or services to be available for sale…

3-4 Pre-launch inventory – Treatment of “in-development” drugs

Background

Company A developed a new drug and needs to have sufficient quantities of inventory on hand in anticipation of commercial launch once regulatory approval to market the product has been obtained. Company A has filed for regulatory approval and is currently awaiting a decision. Company A believes that final regulatory approval is probable.

Company A produced 15,000 doses following submission of the filing for regulatory approval. If regulatory approval is not obtained, the inventory has no alternative use. Company A measures inventory using FIFO.

Question: How should the costs associated with the production of pre-launch inventory for drugs in-development be accounted for?

Solution

Pre-launch inventory can be capitalized if it has probable future economic benefit, which is assessed based on the individual facts and circumstances. Factors to consider include whether key safety, efficacy, and feasibility issues have been resolved, the status of any advisory committee reviews, and an understanding of any potential hurdles to regulatory approval or product reimbursement.

Company A has filed for regulatory approval and believes future economic benefit is probable. Accordingly, the pre-launch inventory can be capitalized at the lower of cost or net realizable value. Periodic reassessments should be made to determine whether the inventory continues to have a probable future economic benefit (e.g., whether regulatory approval is still probable and whether the product will be sold prior to its expiration). If at any time regulatory approval is not deemed to be probable, the inventory should be written down to its net realizable value, which is presumably zero as it must be assumed that the product cannot be sold.  If the value of inventory is written down, the reduced amount is the new cost basis (i.e., if regulatory approval is ultimately obtained, the inventory is not written back up).

Companies should consider whether additional financial statement disclosures are necessary related to the capitalization of pre-launch inventory, including the judgments around the probable future benefit and total amount capitalized.

Further, if inventory that had previously been written down is ultimately sold, companies should consider disclosing the impact on margins.

Relevant guidance

CON 6, par. 25: Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

ASC 330-10-20: Inventory: The aggregate of those items of tangible personal property that have any of the following characteristics: (a) held for sale in the ordinary course of business, (b) in process of production for such sale, or (c) to be currently consumed in the production of goods or services to be available for sale…

ASC 330-10-30-1: The primary basis of accounting for inventories is cost, which has been defined generally as the price paid or consideration given to acquire an asset. As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. It is understood to mean acquisition and production cost, and its determination involves many considerations.

ASC 330-10-35-1B: Inventory measured using any method other than LIFO or the retail inventory method (for example, inventory measured using first-in, first-out (FIFO) or average cost) shall be measured at the lower of cost and net realizable value. When evidence exists that the net realizable value of inventory is lower than its cost, the difference shall be recognized as a loss in earnings in the period in which it occurs. That loss may be required, for example, due to damage, physical deterioration, obsolescence, changes in price levels, or other causes.

3-5 Recognition of raw materials as inventory

Background

Company A buys bulk materials used for manufacturing a variety of drugs. The materials are used for marketed drugs, samples, and drugs in development. The materials are warehoused in a common facility and released to production based upon orders from the manufacturing and development departments.

Question: How should purchased materials be accounted for when their ultimate use is not known?

Solution

Raw material costs can be capitalized to the extent the inventory has probable future economic benefit. Therefore, Company A should account for the raw materials that can be used in the production of marketed drugs as inventory.

When the material is consumed in the production of sample products, Company A should account for the sample product to be given away as an expense in accordance with its policy, which would generally be either when the product is packaged as sample product or the sample is distributed. When the materials are released to production for use in the manufacturing of drugs in development, the cost of the materials should be accounted for as research and development expense.

Alternatively, if the bulk materials were only able to be used for a particular research and development project, and did not have alternative future uses, the costs would be recognized as research and development expense when incurred, which would typically be when the bulk material is received by Company A.

Relevant guidance

ASC 330-10-20: Inventory: The aggregate of those items of tangible personal property that have any of the following characteristics: (a) held for sale in the ordinary course of business, (b) in process of production for such sale, or (c) to be currently consumed in the production of goods or services to be available for sale.

ASC 730-10-25-2]: …The costs of materials (whether from the entity’s normal inventory or acquired specially for research and development activities) and equipment or facilities that are acquired or constructed for research and development activities and that have alternative future uses (in research and development projects or otherwise) shall be capitalized as tangible assets when acquired or constructed. The cost of such materials consumed in research and development activities and the depreciation of such equipment of facilities used in those activities are research and development costs. However, the costs of materials, equipment, or facilities that are acquired or constructed for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred…

3-6 Indicators of impairment – Inventory

Background

Company A has decided to temporarily suspend all operations at a certain production site due to identified quality issues. Company A initiated a recall of products manufactured at that site to be destroyed upon return. Company A carries a significant amount of raw material inventory used in the manufacturing of the recalled product. There is no work-in-process on hand at the time operations are suspended.

Question: How should Company A assess if an impairment may exist?

Solution

Company A would need to consider all available evidence to determine if there is an impairment. Suspending production and recalling the product are indicators that the carrying value of raw material inventory used to manufacture the drug, as well as any related finished goods on hand, may not be recoverable. Company A would need to evaluate the reason for the recall, its history with past recalls, the likelihood that the quality issue could be fixed, and if the raw materials have an alternative use.

In addition to product recalls, the following events are typical indicators within the pharmaceutical and life sciences industry that may trigger the need for an impairment test:

  • Patent expiration

  • Failure to meet regulatory or internal quality requirements

  • Product or material obsolescence

  • Market entrance of competitor products

  • Changes or anticipated changes in third-party reimbursement policies that will impact the selling price of the inventory

Relevant guidance

ASC 330-10-35-1B: Inventory measured using any method other than LIFO or the retail inventory method (for example, inventory measured using first-in, first-out (FIFO) or average cost) shall be measured at the lower of cost and net realizable value. When evidence exists that the net realizable value of inventory is lower than its cost, the difference shall be recognized as a loss in earnings in the period in which it occurs. That loss may be required, for example, due to damage, physical deterioration, obsolescence, changes in price levels, or other causes.

ASC 330-10-35-1C: A departure from the cost basis of pricing inventory measured using LIFO or the retail inventory method is required when the utility of the goods is no longer as great as their cost. Where there is evidence that the utility of goods, in their disposal in the ordinary course of business, will be less than cost, whether due to damage, physical deterioration, obsolescence, changes in price levels, or other causes, the difference shall be recognized as a loss of the current period. This is generally accomplished by stating such goods at a lower level commonly designated as market.

3-7 Accounting for patent-related costs

Background

Company A has filed a number of patent applications and has incurred external legal and related costs in connection with the applications. Company A has also incurred legal costs in defense of its patents.

Question: Should legal costs relating to the defense of patents be capitalized?

Solution

Determining whether to capitalize or expense patent application costs involves judgment. To capitalize patent application costs, there must be probable future economic benefit, otherwise, the costs would need to be expensed. For example, if Company A’s product is in the research and development phase and has not yet been approved for commercialization, the costs incurred in connection with the patent application should generally be expensed in the income statement because there is uncertainty as to the product’s future economic benefit. If, on the other hand, a future economic benefit is probable, or it has an alternate future use, the application costs could be capitalized and amortized over the expected life of the patent.

Company A can also capitalize external legal costs incurred in the defense of its patents when a successful defense is probable and the future economic benefit of the patent is expected to increase as a result. Capitalized patent defense costs are amortized over the remaining life of the related patent. When the defense of the patent only maintains (rather than increases) its expected future economic benefit, the costs would generally be expensed as incurred. Losses to defend allegations of infringement against other parties’ patents are generally not in the defense of a company’s own patents.

Relevant guidance

CON 6, par 25: Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

CON 6, par 247: ...the legal and other costs of successfully defending a patent from infringement are “deferred legal costs” only in the sense that they are part of the cost of retaining and obtaining the future economic benefit of the patent.

AICPA Technical Practice Aids, Technical Questions and Answers Section 2260: If defense of the patent lawsuit is successful, costs may be capitalized to the extent of an evident increase in the value of the patent. Legal costs which relate to an unsuccessful outcome should be expensed.

3-8 Accounting for contingent insurance proceeds

Background

Company A is waiting to hear from Company B, an insurance company, with respect to a claim that was filed in the second quarter of 20X8. The claim was filed as a result of an accident at one of Company A’s production facilities that occurred late in the first quarter of 20X8, resulting in a period of business interruption.

The accident involved a production machine, which is an important component of one of Company A’s production lines. The machine will need to be completely refurbished at a cost of $5 million and will not be available for use until the fourth quarter of 20X8. Company A asserts it will lose $10 million in sales while the machine is out of service.

Company A’s insurance policy covers the full amount of the claim ($15 million). Company A believes it is clear the insurance policy covers its claim and does not anticipate coverage disputes by its carrier.

Question: How should Company A analyze the components of the insurance claim?

Solution

Company A should analyze the two components of this insurance claim separately.

The claim for lost revenues (business interruption) should be assessed using a gain contingency model under ASC 450–30 because of the inherent judgment involved in determining allowable claims and their amounts, and because no accounting loss was recorded. Therefore, recognition of the gain would likely not be appropriate prior to the carrier acknowledging that the claim is covered under the insurance policy and the amount to be paid to Company A. At that point, the carrier’s ability to pay the amount would need to be validated (at which point the gain would be considered realizable) before a receivable was recorded.

The damage to the equipment meets the ASC 610-30-25-3 definition of an involuntary conversion of a nonmonetary asset (machinery) to a monetary asset (insurance proceeds). If Company A believes that recovery of these losses from the insurer is probable, it should recognize an asset representing its best estimate of the amount it will recover. This amount should not exceed the amount of actual accounting loss to which the recovery relates (e.g., the impairment of the cost of the machine in this case). This accounting treatment is consistent with the guidance in ASC 410–30–35 (recoveries related to environmental remediation liabilities). In performing this probability assessment, Company A would likely consider (among other things) the terms and clarity of the existing agreement with Company B, the viability of Company B, and whether Company A has an established history of prior claims with Company B. Any potential proceeds in excess of the loss recorded on the asset for accounting purposes (i.e., if the asset was destroyed and the claim was for its fair value, which exceeded its book value) are considered a gain contingency and should be assessed as such as discussed for the business interruption claim.

Relevant guidance

ASC 610-30-25-3: Involuntary conversions of nonmonetary assets to monetary assets are monetary transactions for which gain or loss shall be recognized even though an entity reinvests or is obligated to reinvest the monetary assets in replacement nonmonetary assets...

ASC 450-30-25-1: A contingency that might result in a gain usually should not be reflected in the financial statements because to do so might be to recognize revenue before its realization.

ASC 450-20-25-2: An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

  • Information available before the financial statements are issued or are available to be issued... indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements…

  • The amount of the loss can be reasonably estimated.

The purpose of those conditions is to require accrual of losses when they are reasonably estimable and relate to the current or a prior period...

ASC 410-30-35-8: … An asset relating to the recovery shall be recognized only when realization of the claim for recovery is deemed probable…

3-9 Selling raw materials to and purchasing finished goods from a subcontractor

Background

Company A outsources the manufacturing of certain products to Company B. Company A purchases and then sells the raw materials to Company B, which processes the raw materials into finished goods. Company A is then obligated to repurchase the finished goods from Company B.

At the time of sale of the raw materials (at which point transfer of control passes), Company A invoices Company B and executes a purchase order to purchase from Company B a specific quantity of finished goods. Company B invoices Company A for the finished goods when delivered to Company A. Company B has physical risk of loss associated with the raw materials once received. The price of the finished goods purchased by Company A far exceeds the price Company B pays to buy the raw materials from Company A.

Question: How should Company A record the sale of raw materials to Company B?

Solution

Although not explicitly in its scope, in this example, it is appropriate to analogize to the guidance in ASC 470-40-25-2(a). Consistent with ASC 470–40–25–2(a) and ASC 606-10-55-66, Company A should retain the raw materials on its books (effectively, as consigned inventory) when they are “sold” to Company B. Any consideration received from Company B in advance of Company A’s repurchase of the finished goods should be accounted for as a financial liability. The liability would be relieved upon payment to Company B for the finished goods.

Relevant guidance

ASC 470-40-05-2: Product financing arrangements include agreements in which a sponsor (the entity seeking to finance product pending its future use or resale) does any of the following: (a) Sells the product to another entity (the entity through which the financing flows), and in a related transaction agrees to repurchase the product (or a substantially identical product)...

ASC 470-40-05-3:... For an arrangement described in 2(a), see topic 606 revenue from contracts with customers for guidance on repurchase agreements in paragraphs 606-10-55-66 through 55-78 and an illustration on repurchase agreements in Example 62, Case A, paragraphs 606-10-55-401 through 55-404.

ASC 470-40-25-2(a):  If a sponsor sells a product to another entity and, in a related transaction, agrees to repurchase the product (or a substantially identical product) or processed goods of which the product is a component, the sponsor shall record a liability at the time the proceeds are received from the other entity to the extent that the product is covered by the financing arrangement. The sponsor shall not record the transaction as a sale and shall not remove the covered product from its balance sheet.

ASC 606-10-55-66: A repurchase agreement is a contract in which an entity sells an asset and also promises or has the option (either in the same contract or in another contract) to repurchase the asset.  The repurchased asset may be the asset that was originally sold to the customer, an asset that is substantially the same as that asset, or another asset of which the asset that was originally sold is a component.

ASC 606-10-55-70: If the repurchase agreement is a financing arrangement, the entity should continue to recognize the asset and also recognize a financial liability for any consideration received from the customer...

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Laura Robinette

US Pharmaceutical & Life Sciences Assurance Leader, PwC US

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